What went wrong? After a summer of quantitative pain, Amir Khandani and Andrew Lo have tested the theory that hedge funds have grown and proliferated to the point where in rushing for the exit from commonly held positions, they collide - and in some cases just knock each other out.
The authors of the MIT paper, ‘What happened to the quants in August 2007?’, call their findings “tentative” - based on indirect evidence and modelling of a “simplistic” long-short strategy - but suggest that the decisive factor behind the pain of the quants wasn’t quantitative at all.
Dealbreaker notes that the boffins largely confirm the theory laid out by Lehman analyst Matthew Rothman in the midst of the turmoil. The rapid unwinding of one or more large long/short portfolios - most likely a quantitative equity market-neutral portfolio - created a “cascade effect” that ultimately spread more broadly - to other long/short books, 130/30 strategies, and certain long-only portfolios.
The fact that quants were hit with “laser-like precision” on August 7 and 8 had more to do with the nature of the shock - hitting all equity market-neutral funds that are, by necessity, quantitatively managed - rather than the fact that they were computer driven per se.
Good news for the quants then. The study’s first conclusion is that:
The events of August 2007 are not particularly relevant to the efficacy of quantitative investing. The losses were more likely the result of a firesale liquidation of quantitatively constructed portfolios rather than the specific shortcomings of quantitative methods.
But there’s an indigestible morsel for all hedge funds at the end of Khandani and Lo’s report. The fact, they add, that the dislocation of long-short portfolios lay elsewhere - in unrelated markets and instruments - suggests that systemic risk may have increased in the industry.
Events in 1998 took traders by surprise because default of Russian government debt sparked a process that ultimately resulted in the demise of LTCM and other funds. But, the authors warn:
August 2007 is far more significant because it provides the first piece of evidence that problems in one corner of the financial system - possibly the sub-prime mortgage and related credit markets - can spill over so directly to a completely unrelated corner: long/short equity strategies.
The episode has also given weight to the notion of ‘hedge-fund beta’, say Khandani and Lo - and will redouble efforts by those wanting to cheaply replicate hedge fund returns. And the outlook for regulatory oversight of the hedge fund industry is also unpalatable for the funds. The current regulatory structure for oversight and management of hedge funds is lacking - and their role as active providers of liquidity and credit means that their actions are now widely felt.
Hedge funds are becoming more like banks, and the reason that the banking industry is so highly regulated is precisely because of the enormous social externalities banks generate when they succeed, and when they fail. Unlike banks, hedge funds can decide to withdraw liquidity at a moment’s notice, and while this may be acceptable if it occurs rarely and randomly, a coordinated withdrawal of liquidity among an entire sector of hedge funds could have disastrous consequences for the viability of the financial system if it occurs at the wrong time and in the wrong sector.
They conclude:
If we were to develop a Doomsday Clock for the hedge-fund industry’s impact on the global financial system, calibrated to 5 minutes to midnight in August 1998, and 15 minutes to midnight in January 1999, then our current outlook for the state of systemic risk in the hedge-fund industry is about 11:51pm.
For the moment, markets seem to have stabilized, but the clock is ticking…
